M06 Mish1520 06 PPW C05

Chapter 5
How Do The Risk

and Term
Structure Affect
Interest Rates
Chapter Preview
In the last chapter, we examined interest
rates, but made a big assumption there is
only one economy-wide interest rate. Of
course, that isnt really the case.
In this chapter, we will examine the
different rates that we observe for financial
products.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
5-2
Chapter Preview
We will fist examine bonds that offer similar
payment streams but differ in price. The
price differences are due to the risk
structure of interest rates. We will
examine in detail what this risk structure
looks like and ways to examine it.
5-3
Chapter Preview
Next, we will look at the different rates
required on bonds with different maturities.
That is, we typically observe higher rates
on longer-term bonds. This is known as
the term structure of interest rates. To
study this, we usually look at Treasury
bonds to minimize the impact of other risk
factors.
5-4
Chapter Preview
So, in sum, we will examine how the
individual risk of a bond affects its required
rate. We also explore how the general
level of interest rates varies with the
maturity of the debt instruments. Topics
include:
Risk Structure of Interest Rates
Term Structure of Interest Rates
5-5
Risk Structure of Interest Rates

To start this discussion, we first examine
the yields for several categories of longterm bonds over the last 85 years.
You should note several aspects regarding
these rates, related to different bond
categories and how this has changed
through time.
5-6
Risk Structure
of Long Bonds in the U.S.
5-7
Risk Structure
of Long Bonds in the U.S.
The figure show two important features of
the interest-rate behavior of bonds.
Rates on different bond categories

change from one year to the next.
Spreads on different bond categories

change from one year to the next.
5-8
Factors Affecting Risk Structure

of Interest Rates
To further examine these features, we will
look at three specific risk factors.
Default Risk
Liquidity
Income Tax Considerations
5-9
Default Risk Factor

One attribute of a bond that influences its
interest rate is its risk of default, which occurs
when the issuer of the bond is unable or
unwilling to make interest payments when
promised.
U.S. Treasury bonds have usually been
considered to have no default risk because the
federal government can always increase taxes
to pay off its obligations (or just print money).
Bonds like these with no default risk are called
default-free bonds.
5-10
Default Risk Factor (cont.)

The spread between the interest rates on bonds
with default risk and default-free bonds, called
the risk premium, indicates how much
additional interest people must earn in order to
be willing to hold that risky bond.
A bond with default risk will always have a
positive risk premium, and an increase in its
default risk will raise the risk premium.
5-11
Increase in Default Risk

on Corporate Bonds
5-12
Analysis of Figure 5.2: Increase in

Default on Corporate Bonds
Corporate Bond Market
1. Re on corporate bonds , Dc , Dc shifts left
2. Risk of corporate bonds , Dc , Dc shifts left
3. Pc , ic
Treasury Bond Market

4. Relative Re on Treasury bonds , DT , DT shifts right
5. Relative risk of Treasury bonds , DT , DT shifts right
6. PT , iT
Outcome
Risk premium, ic - iT, rises
5-13
Default Risk Factor (cont.)

Default risk is an important component of the
size of the risk premium.
Because of this, bond investors would like to
know as much as possible about the default
probability of a bond.
One way to do this is to use the measures
provided by credit-rating agencies: Moodys and
S&P are examples.
5-14
Bond Ratings
5-15
Case: Enron and the Baa-Aaa spread

Enron filed for bankruptcy in December
2001, amidst an accounting scandal.
Because of the questions raised about
the quality of auditors, the demand for
lower-credit bonds fell, and a flightto-quality followed (demand for Tsecurities increased.
Result: Baa-Aaa spread increased from
84 bps to 128 bps.
5-16
Liquidity Factor
Another attribute of a bond that influences
its interest rate is its liquidity; a liquid asset
is one that can be quickly and cheaply
converted into cash if the need arises. The
more liquid an asset is, the more desirable
it is (higher demand), holding everything
else constant.
Lets examine what happens if a corporate

bond becomes less liquid (Figure 1 again).
5-17
Decrease in Liquidity
of Corporate Bonds
Figure 5.2 Response to a Decrease in the Liquidity of Corporate Bonds

5-18
Analysis of Figure 5.1: Corporate Bond

Becomes Less Liquid
Corporate Bond Market
1. Liquidity of corporate bonds , Dc , Dc shifts left
2. Pc , ic

1. Relatively more liquid Treasury bonds, DT , DT shifts right
2. PT , iT
Outcome
Risk premium, ic - iT, rises
Risk premium reflects not only corporate bonds' default

risk but also lower liquidity
5-19
Liquidity Factor (cont.)

The differences between interest rates on
corporate bonds and Treasury bonds (that
is, the risk premiums) reflect not only the
corporate bonds default risk but its liquidity
too. This is why a risk premium is
sometimes called a risk and liquidity
premium.
5-20
Income Taxes Factor

An odd feature of Figure 1 is that municipal
bonds tend to have a lower rate the
Treasuries. Why?
Munis certainly can default. Orange
County (California) is a recent example
from the early 1990s.
Munis are not as liquid a Treasuries.
5-21
Income Taxes Factor

However, interest payments on municipal
bonds are exempt from federal income
taxes, a factor that has the same effect on
the demand for municipal bonds as an
increase in their expected return.
Treasury bonds are exempt from state and
local income taxes, while interest payments
from corporate bonds are fully taxable.
5-22
Income Taxes Factor

For example, suppose you are in the 35%
tax bracket. From a 10%-coupon Treasury
bond, you only net $65 of the coupon
payment because of taxes
However, from an 8%-coupon muni, you
net the full $80. For the higher return, you
are willing to hold a riskier muni (to a point).
5-23
Tax Advantages of Municipal Bonds
5-24
Analysis of Figure 5.3:

Tax Advantages of Municipal Bonds
Municipal Bond Market
1. Tax exemption raises relative Re on municipal
bonds,
Dm , Dm shifts right
2. Pm

1. Relative Re on Treasury bonds , DT , DT shifts left
2. PT
Outcome
im < iT
5-25
Case: Bush Tax Cut and Interest Rates

The 2001 tax cut called for a reduction in
the top tax bracket, from 39% to 35% over
a 10-year period.
This reduces the advantage of municipal
debt over T-securities since the interest
on T-securities is now taxed at a lower
rate.
5-26
Term Structure of Interest Rates

Now that we understand risk, liquidity, and
taxes, we turn to another important
influence on interest rates maturity.
Bonds with different maturities tend to have
different required rates, all else equal.
5-27
The WSJ: Following the News

For example, the WSJ publishes a plot of
the yield curve (rates at different
maturities) for Treasury securities.
The picture on page 107 of your text is a
typical example, from May 14, 2007.
What is the 3-month rate? The two-year

rate?
5-28
Term Structure Facts to Be Explained

Besides explaining the shape of the yield
curve, a good theory must explain why:
Interest rates for different maturities
move together. We see this on the next
slide.
5-29
Interest Rates on Different Maturity

Bonds Move Together
5-30
Term Structure Facts to Be Explained

Besides explaining the shape of the yield
curve, a good theory must explain why:
Interest rates for different maturities
move together.
Yield curves tend to have steep upward
slope when short rates are low and
downward slope when short rates are high.
Yield curve is typically upward sloping.
5-31
Three Theories of Term Structure

1. Expectations Theory
Pure Expectations Theory explains 1 and 2,

but not 3
2. Market Segmentation Theory
Market Segmentation Theory explains 3, but not 1

and 2
3. Liquidity Premium Theory
Solution: Combine features of both Pure

Expectations Theory and Market Segmentation
Theory to get Liquidity Premium Theory and explain
all facts
5-32
Expectations Theory
Key Assumption: Bonds of different
maturities are perfect substitutes
Implication: Re on bonds of different
maturities are equal
5-33
Expectations Theory
To illustrate what this means, consider two
alternative investment strategies for a twoyear time horizon.
1. Buy $1 of one-year bond, and when it
matures, buy another one-year bond with
your money.
2. Buy $1 of two-year bond and hold it.
5-34
Expectations Theory
The important point of this theory is that if
the Expectations Theory is correct, your
expected wealth is the same (a the start)
for both strategies. Of course, your actual
wealth may differ, if rates change
unexpectedly after a year.
We show the details of this in the next few
slides.
5-35
Expectations Theory
Expected return from strategy 1
(1 it )(1 i ) 1 1 it i
e
t 1
e
t 1
it (i ) 1
e
t 1
Since it(iet+1) is also extremely small,

expected return is approximately
it + iet+1
5-36
Expectations Theory
Expected return from strategy 2
(1 i2t )(1 i2t ) 1 1 2(i2t ) (i2t )2 1

Since (i2t)2 is extremely small, expected return is approximately
2(i2t)
5-37
Expectations Theory
From implication above expected returns of two
strategies are equal
Therefore
2i2t it i
e
t 1
Solving for i2t
it ite1
i2t
2
(1)
5-38
Expectations Theory
To help see this, heres a picture that
describes the same information:
5-39
More generally for n-period bond
int
it it 1 it 2 ... it n1
n
(2)
Dont let this seem complicated. Equation

2 simply states that the interest rate on a
long-term bond equals the average of short
rates expected to occur over life of the
long-term bond.
5-40
More generally for n-period bond

Numerical example
One-year interest rate over the next five years
are expected to be 5%, 6%, 7%, 8%, and 9%
Interest rate on two-year bond today:

(5% + 6%)/2 = 5.5%
Interest rate for five-year bond today:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
Interest rate for one- to five-year bonds today:

5%, 5.5%, 6%, 6.5% and 7%
5-41
Expectations Theory
and Term Structure Facts
Explains why yield curve has different slopes
1. When short rates are expected to rise in future,
average of future short rates = int is above today's
short rate; therefore yield curve is upward sloping.
2. When short rates expected to stay same in future,

average of future short rates same as today's, and
yield curve is flat.
3. Only when short rates expected to fall will yield curve
be downward sloping.
5-42
Expectations Theory
Pure expectations theory explains fact 1

that short and long rates move together
1. Short rate rises are persistent
2. If it today, iet+1, iet+2 etc.

average of future rates int
3. Therefore: it int
(i.e., short and long rates move together)
5-43
Expectations Theory
Explains fact 2that yield curves tend to have
steep slope when short rates are low and
downward slope when short rates are high
1. When short rates are low, they are expected to rise
to normal level, and long rate = average of future
short rates will be well above today's short rate;
yield curve will have steep upward slope.
2. When short rates are high, they will be expected to
fall in future, and long rate will be below current
short rate; yield curve will have downward slope.
5-44
Expectations Theory
Doesn't explain fact 3that yield curve
usually has upward slope
Short rates are as likely to fall in future as rise,
so average of expected future short rates will
not usually be higher than current short rate:
therefore, yield curve will not usually
slope upward.
5-45
Market Segmentation Theory

Key Assumption:
Bonds of different maturities are

not substitutes at all
Implication:
Markets are completely segmented;

interest rate at each maturity are
determined separately
5-46
Market Segmentation Theory

Explains fact 3that yield curve is usually
upward sloping
People typically prefer short holding periods and thus have
higher demand for short-term bonds, which have higher
prices and lower interest rates than long bonds
Does not explain fact 1or fact 2 because its

assumes long-term and short-term rates are
determined independently.
5-47
Liquidity Premium Theory

Key Assumption:
Bonds of different maturities

are substitutes, but are not
perfect substitutes
Implication:
Modifies Pure Expectations

Theory with features of Market
Segmentation Theory
5-48

Investors prefer short-term rather than long-term
bonds. This implies that investors must be paid
positive liquidity premium, int, to hold long term
bonds.
5-49

Results in following modification of Expectations
Theory, where lnt is the liquidity premium.
int
it i
e
t 1
e
t2
... i
e
t n1
nt
(3)
We can also see this graphically
5-50
5-51
Numerical Example
1. One-year interest rate over the next five
years: 5%, 6%, 7%, 8%, and 9%
2. Investors' preferences for holding shortterm bonds so liquidity premium for oneto five-year bonds: 0%, 0.25%, 0.5%,
0.75%, and 1.0%
5-52
Numerical Example
Interest rate on the two-year bond:
0.25% + (5% + 6%)/2 = 5.75%
Interest rate on the five-year bond:
1.0% + (5% + 6% + 7% + 8% + 9%)/5 = 8%
Interest rates on one to five-year bonds:

5%, 5.75%, 6.5%, 7.25%, and 8%
Comparing with those for the pure expectations
theory, liquidity premium theory produces yield
curves more steeply upward sloped
5-53
Liquidity Premium Theory:

Term Structure Facts
Explains All 3 Facts
Explains fact 3that usual upward sloped
yield curve by liquidity premium for
long-term bonds
Explains fact 1 and fact 2 using same
explanations as pure expectations theory
because it has average of future short rates as
determinant of long rate
5-54
Market
Predictions
of Future
Short Rates
Evidence on the Term Structure

Initial research (early 1980s) found little
useful information in the yield curve for
predicting future interest rates.
Recently, more discriminating tests show
that the yield curve has a lot of information
about very short-term and long-term rates,
but says little about medium-term rates.
5-56
Case: Interpreting Yield Curves

The picture on the next slide illustrates
several yield curves that we have observed
for U.S. Treasury securities in recent years.
What do they tell us about the publics
expectations of future rates?
5-57
Case: Interpreting Yield Curves, 1980

2008
5-58

The steep downward curve in 1981
suggested that short-term rates were
expected to decline in the near future. This
played-out, with rates dropping by 300 bps
in 3 months.
The upward curve in 1985 suggested a rate
increase in the near future.
5-59

The slightly upward slopes in the remaining
years can be explained by liquidity
premiums. Short-term rates were stable,
with longer-term rates including a liquidity
premium (explaining the upward slope).
5-60
Mini-case: The Yield Curve as a

Forecasting Tool
The yield curve does have information
about future interest rates, and so it should
also help forecast inflation and real output
production.
Rising (falling) rates are associated with
economic booms (recessions) [chapter 4].
Rates are composed of both real rates and
inflation expectations [chapter 3].
5-61
The Practicing Manager: Forecasting Interest

Rates with the Term Structure
Pure Expectations Theory: Invest in 1-period bonds
or in two-period bond
1 it 1 ite1 1 1 i2t 1 i2t 1

Solve for forward rate, iet+1
1 i2t
e
t 1
1 it
(4)
Numerical example: i1t = 5%, i2t = 5.5%

ite1
1 0.0552
1 0.05
1 0.06 6%
5-62
Forecasting Interest Rates

with the Term Structure
Compare 3-year bond versus 3 one-year bonds
1 it 1 ite1 1 ite2 1 1 i3t 1 i3t 1 i3t 1

Using iet+1 derived in (4), solve for iet+2
1 i3t
2 1
1 i2t
3
e
t 2
5-63

Generalize to:
1 in1t
n
1 int
n 1
e
t n
(5)
Liquidity Premium Theory: int = same as pure

expectations theory; replace int by int in (5)
to get adjusted forward-rate forecast
1 in1t n 1t
n
1 int nt
n1
e
t n
(6)
5-64

Numerical Example
2t = 0.25%, 1t=0, i1t=5%, i2t = 5.75%
2
0.0575
0.0025
ite1
1 0.06 6%
1 0.05
Example: 1-year loan next year

T-bond + 1%, 2t = .4%, i1t = 6%, i2t = 7%
2
0.07
0.004
ite1
1 0.072 7.2%
1 0.06
Loan rate must be > 8.2%

5-65
Chapter Summary
Risk Structure of Interest Rates: We
examine the key components of risk in
debt: default, liquidity, and taxes.
Term Structure of Interest Rates: We
examined the various shapes the yield
curve can take, theories to explain this, and
predictions of future interest rates based on
the theories.
5-66

M06 Mish1520 06 PPW C05

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

M06 Mish1520 06 PPW C05

Uploaded by

Copyright:

Available Formats

Chapter 5

How Do The Risk

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Risk Structure of Interest Rates

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Rates on different bond categories

Spreads on different bond categories

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Factors Affecting Risk Structure

Income Tax Considerations

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Default Risk Factor

Default Risk Factor (cont.)

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Increase in Default Risk

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Analysis of Figure 5.2: Increase in

Treasury Bond Market

Default Risk Factor (cont.)

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Case: Enron and the Baa-Aaa spread

Lets examine what happens if a corporate

Figure 5.2 Response to a Decrease in the Liquidity of Corporate Bonds

Analysis of Figure 5.1: Corporate Bond

Treasury Bond Market

Risk premium, ic - iT, rises

Risk premium reflects not only corporate bonds' default

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Liquidity Factor (cont.)

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Income Taxes Factor

Munis are not as liquid a Treasuries.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Income Taxes Factor

Income Taxes Factor

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Tax Advantages of Municipal Bonds

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Analysis of Figure 5.3:

Treasury Bond Market

Case: Bush Tax Cut and Interest Rates

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Term Structure of Interest Rates

Copyright 2009 Pearson Prentice Hall. All rights reserved.

The WSJ: Following the News

What is the 3-month rate? The two-year

Term Structure Facts to Be Explained

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Interest Rates on Different Maturity

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Term Structure Facts to Be Explained

Three Theories of Term Structure

Pure Expectations Theory explains 1 and 2,

2. Market Segmentation Theory

Market Segmentation Theory explains 3, but not 1

3. Liquidity Premium Theory

Solution: Combine features of both Pure

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.